Presentation on theme: "The Economics Of Road Investment"— Presentation transcript:
1The Economics Of Road Investment John HineETWTRThere are 3 main elements to this talk:1) How are the benefits and costs of road construction calculated?Benefits - what are the benefits to road constructionVOC savingsDevelopment benefits (increased agricultural/industrial activity & generated traffic)Costs - how do economic costs differ from financial costsLabourEquipment2) What are the cost consequences of choice of technology?Physical factors - utilisation, haul distances, labour productivityFinancial factors - wage rate, equip costs etc.Economic factors - forex, employment3) What are the wider implications for employment & developmentGov policy on employmentenvironmentwomen& self sufficiencySE197
2Questions and Decisions 1. Is the project justified ?- Are benefits greater than costs?Which is the best investment if we have a set of mutually exclusive alternatives?If funds are limited, how should different schemes be ranked?When should the road be built?
3Questions and Decisions 2. Are complementary investments required?Should stage construction be used?What standards should be applied ?
4Appraisal Framework All appraisals need a framework or model for: a) Forecasting changesb) Evaluating those changes
5The Costs of Road Investment These include:SupervisionManagementManpowerMachineryMaterialsLandEnvironmental Mitigation (e.g. Resettlement)1) Management - This is particularly important in labour based works2) Manpower - we will look at how we cost labour in construction projects3) Machinery - even very labour intensive projects will have an element of equipment that needs costing.4) Materials - gravels, concrete, wood etc.5) Land - It maybe that land will need to be acquired for the road construction. All these items need to be included in an economic appraisal.SE697
6Primary Effects 1. Reduced vehicle operating costs fuel and lubricants vehicle maintenancedepreciation and interestoverheadsReduced journey timedrivers, passengers andgoods
7Primary Effects 2. Changes in road maintenance costs Changes in accident ratesIncreased travelEnvironmental effectsChange in value of goods moved
8Secondary Effects Changes in agricultural output Changes in services Changes in industrial outputChanges in consumers behaviourChanges in land values
9Coverage and Double Counting Any economic analysis should be designed to give maximum coverage of benefits.But we must avoid double counting. Do not add primary and secondary benefits (e.g changes in land values added to changes in transport costs)In a competitive economy the consumers’ surplus approach (used in HDM) should be adequate.
10The Economic Comparison An economic analysis involves a comparison of “With” and “Without” cases.Traffic forecasts are made for BOTH scenarios - The analysis should not be based on “before and after”.An unrealistic “Without” case can give a false result.A range of “with investment” cases should be analysed to find the best solution. A minimum investment approach often gives the best economic results and should be tested.
11Economic and Financial Prices The cost to the economy of road rehabilitation and maintenance may differ from the financial cost because of :taxes and dutiesshortage of foreign exchangeunder-employmentTo reiterate what has already been said - the cost to the economy of road rehabilitation and maintenance may differ from financial costs because of:1) Taxes and duties - important for costing equipment2) A shortage of foreign exchange or overvalued currencies - adjustments need to be made because in the past international contractors may have appeared cheaper than domestic contractors. An economic analysis will show this to be false. Important for costing equipment.3) Labour needs to be valued at its real cost - rural un or under employment may mean that the real cost of labour is below the wage rate for labour in the organised sector. The next slide will show how we deal with labour. Important for labour intensive works.The Government will usually be concerned with ECONOMIC costs.Contractors will usually be concerned with FINANCIAL costs.SE897
12Use of Economic PricesIn an Economic Appraisal we use ECONOMIC (or SHADOW) prices NOT FINANCIAL pricesAdjust financial prices as follows:Exclude all taxes and duties and subsidiesUse the planning discount rate not the financial market rateIf overvalued exchange rate then valueimports and exports more highlyUse the opportunity cost of labourStandard Conversion Factors are now widely used forroad construction costsAn economist uses ECONOMIC/SHADOW/ACCOUNTING prices.Interested in the impact of a project on the economy as a whole. For this reason we need to adjust financial prices to take out any distortions which affect the true market price of resources.1) taxes and duties should be excluded but subsidies included. For example import duties imposed by government on the purchase of imported graders should be excluded from any calculations.2) Planning discount rate should be used and not a financial rate. The planning discount rate can be obtained from the ministry of planning & finance etc.. The discount rate represents what the government sees as an acceptable return to capital. It will be the same in the roads sector as in forestry, health and education etc.3) Where currencies have been overvalued, because of gov intervention, it may be necessary to value imports and exports more highly. This is not such a common problem now because of widespread economic adjustment programmes.4) Of primary importance in labour intensive works is to value labour at its real value and not at an artificially set minimum wage.SE797
13Benefits From Road Investment Changes in transport costs occur because of :Lower road roughnessShorter trip distanceFaster speedsReduced chance of impassabilityReduced traffickability problemsChange in mode
14Traffic CategoriesNormal traffic: Existing traffic and growth that would occur on the same road, with and without the investmentDiverted traffic: Traffic diverted from another road to the project road as a result of the investmentGenerated traffic: New traffic induced by the investmentSlide is self explanatory. Traffic is measured in person km, tonne km and/or vehicle km.Normal traffic: Component of traffic where trip numbers and trip distances are same for “with” and “without” cases, but unit costs per vehicle km may be different.Diverted traffic: Component of traffic that diverts to a cheaper route. Trip numbers are same for “with” and “without” cases but trip distances and unit costs per vehicle km will be different.Generated traffic: Traffic component whereby entirely new trips are induced.Note for the purposes of economic analysis “redistributed trips” (this is used in urban transportation modelling, it refers to trips where there is a change of destination as a result of investment) may be treated in the same way as diverted traffic.
15Benefits from Road Investment Transport cost savings for existing (or normal ) traffic= Traffic x Change in Transport Costs perkm x distanceMain changes in cost from:a) change in transport MODEb) reduced journey TIMEc) reduced VOCsTransport cost savings are calculated as:Traffic * change in transport costsIn this context traffic includes headloading, bullock carts, camels, trucks, cars and buses.The change in transport costs will be much greater if there is a change in transport mode from headloading to trucks.Improved surface condition increases the speed of vehicles and therefore reduces journey times. The benefits come from value of time savings.In a conventional appraisal the majority of benefits come from savings in vehicle operating costs with a change in road roughness.SE297
16Generated Traffic Benefits Traffic induced by the road investment are traditionally valued at:Half the difference in transport costsHence total generated transport cost benefits= Generated traffic volume x change in costs per km x distance x 1/2
17Estimating BenefitsNormal traffic benefits: tripsN * d1 * (VOC1- VOC2)Diverted traffic benefits: tripsD * ((d1 * VOC1)-(d2*VOC2))Generated traffic benefits: tripsG * d2 * (VOC1- VOC2)/2d1 = existing road length d2 new road lengthVOC1 = vehicle operating costs per km “without”investmentVOC2 = vehicle operating costs per km “with” investmentVOC data relates to each road section and its condition at the time1. Normal and generated traffic benefits are calculated in terms of the volume of traffic multiplied by the change in transport costs.2. Generated traffic benefits are calculated in terms of traffic volumes multiplied by half the difference in transport costs. In economic theory the “half” represents the area under the downward sloping demand curve. Because the traffic is induced and is therefore new it cannot gain the full benefits of the change in costs. The “half” is a useful approximation. If the demand curve is strongly convex to the origin then the formula would overstate the benefits.
18The Consumers’ Surplus Approach TotalBenefitsTransport Cost Savings to existingtraffic and normal growth=Cost+Additional benefits from newtraffic and production inducedby new investmentC11) Theory of the demand curve - with an improvement in the quality of a road:Cost of transport goes down (C1 to C2)demand for transport goes up (T1 to T2)2) With road construction or road improvements there are benefits fromexisting trafficgenerated traffic3) These total benefits are compared with the total costs of road construction.If the benefits are greater than the costs the project in economically viableC2T T TrafficSE497
19Development BenefitsDevelopment benefits arise from a combination of increased traffic and reduced transport costs.Benefits may also include :Increased agricultural productionIncreased service provisionIncreased industrial activityDevelopment benefits:increased traffic using the road - through diversion etc.increased economic activity because of the improved road1) Increased agricultural production - reduced transport costs effectively increase fram gate prices and reduce the costs of inputs such as fertiliser. Higher farm gate prices may increase incentives to increase production.2) Increased industrial/commercial activity - reduced transport costs may encourage industry to locate in particular locationsSE397
21Illustration of Benefits HeadloadingC1TrackCostsImprovedroadC2C3T1TrafficT2T3
22Different Types of Benefit Normal traffic benefits= traffic x change in transport costsDevelopment benefits- A function of (change in transport costs)2Social benefits- A function of population x change in transport costs
23Consumer’s Surplus Approach: Advantages: Simple, cost based, traffic approach dependent on predicting changes in trafficDisadvantages: May not address critical factors promoting either rural development or social access
24Producers Surplus Approach Advantages: Draws attention to changes in agricultural output (key economic activity in rural areas)Disadvantages: No reliable way of predicting response- impact studies give widely different answers–it could be based on agricultural supply priceelasticities but this is almost never done; it requiresvery careful examination to use.For most projects benefits are just invented !
25Producers’ Surplus p2 Increased p1 Price & Costs per unit Of output farmgate pricep1lower input costsO O2Output
26Indicies and RankingWidely used for feeder road planning; there are many different approachese.g. i) cost of improvement / populationii) estimated trips / costAdavantages: Speed , simplicity, transparency, many factors can be incorporatedDisadvantages: How do we value widely different factors ? (adding up apples and pears); weightings are not stable ; cannot easily address questions of road standards, timing etc, ; possible double counting
27Community PrioritiesCommunity priorities now often form an important part of feeder road appraisal. It is possible just to ask communities to rank the investments they prefer- both within the road sector or between roads and other investments.Advantages: Community acceptability, use of community knowledgeDisadvantages: Sectional interest groups may dominate voting, community knowledge of area or road impact may be poor
281. Net Present Value: NPV = (B1- C1) + (B2- C2) + … 1. Net Present Value: NPV = (B1- C1) + (B2- C2) + ….. (Bn- Cn) (1 + r) (1 + r) (1 + r )n 2. Internal Rate of Return : solve for i, (IRR) = (B1- C1) + (B2- C2) + ….. (Bn- Cn) (1 + i) (1 + i) (1 + i )n B1, B2 … Bn : Benefits in years 1, 2 … n C1 C Cn : Costs in years 1, 2 …. n r : Planning discount rate , n : planning time horizonNet Present Value. A positive value suggests the project is economically viable. The larger the NPV the better the project. NPV can be used to choose between mutually exclusive projects.Internal Rate of Return. The IRR is a ratio. If the IRR is above the Planning discount rate the the project is economically viable. The higher the IRR the better the project but it cannot be used to decide between mutually exclusive projects (it would be wrong for a small project with a high IRR to displace a larger project with a lower IRR).Both the NPV and IRR are easily used features of computer spreadsheets such as Excel and Lotus 123.
293. Net Present Value/ Investment Cost NPV/ C = NPV/Ci 4. First Year Rate of ReturnFYRR = (B1- C1)CiB1, C1 : Benefits and Costs in year 1.Ci : Road investment costsNet Present Value/Investment Cost (NPV/C) . This is mainly used to rank projects when there is a budget constraint. The higher the ratio the better the project. Projects are ranked in descending order of NPV/C and the highest ranked projects are accepted until the budget is exhausted. HDM-4 used the NPV/C as a ranking tool for the programme analysis. A form of incremental analysis is required if mutually exclusive projects need to be analysed within a budget constrained programme.First Year Rate of Return (FYRR). This ratio is used as a simple indicator of optimal project timing. If the FYRR is less than the planning discount rate then the project should be postponed. If the FYRR is greater than the planning discount rate the the project may be close to being optimal. In fact the FYRR is an imperfect tool of project timing. It depends upon a range of assumptions including a monotonically increasing benefit function (i.e there are no dips or discontinuities), and complications can arise when the road investment is scheduled over a number of years. A more accurate solution solution is to compare differently phased sequences of projects using the NPV approach.
31Economic Comparison of Alternatives When comparing project-alternatives, the Net Present Value (NPV) is used to select the optimal project-alternative (alternative with highest NPV)The Internal Rate of Return (IRR) or the B/C ratio are not recommended to compare alternatives of a given projectAlternatives NPVOptimal Alternative: Highest NPVProject
32Ranking Projects by Economic Priority When comparing the economic priority of different projects, a recommended economic indicator is the NPV per Investment ratioProjectsSelected Alternative Overlay ResealOverlayNPV/Investment2.1PRIORI TY
33Economic Decision Criteria NPV IRR NPV/C FYRREconomic validity v. good v. good v. good poorMutually exclusive v. good poor good# poorprojectsProject timing fair## poor poor goodProject screening poor v. good good poor/robustnessUse with budget fair ## poor v. good poorconstraint# Need incremental analysis## Needs continuous recalculations
34Appraisals & Post Evaluations 1. An Appraisal is carried out before an investment is made. Everything is uncertain.A Post evaluation may be made say 5 years after the investment. The investment is known and 5yrs of with case are known.The without case is unknown as is the remainder of the with case.
35Appraisals & Post Evaluations 2 In Both Cases forecasting and evaluation models are required to come to an answer.Hence we can never be certain about the viability of an investment !